3 (I) DCF Introduction It can be hard to understand how stock analysts come up with value or “fair” value for companies, or why their target price estimates vary so wildly. The answer often lies in how they use the valuation method known as discounted cash flow (DCF). This handout will describe the step-by-step process of calculating discounted cash flow for a fictional company. In simple terms, discounted cash flow tries to work out the value of a company today, based on projections of how much money it's going to make in the future. DCF analysis says that a company is worth all of the cash that it could make available to investors in the future. It is described as "discounted" cash flow because cash in the future is worth less than cash today. For example, let's say someone asked you to choose between receiving $100 today and receiving $100 in a year. Chances are you would take the money today, knowing that you could invest that $100 now and have more than $100 in a year's time. If you turn that thinking on its head, you are saying that the amount that you'd have in one year is worth $100 dollars today - or the discounted value is $100. Making the same calculation for all the cash expected for a company to produce in the future gives a good measure of the company's value. There are variations of the discounted cash flow analysis, including the cash flow to firm approach or free cash flow to equity approach commonly used by Wall Street analysts to determine the "fair value" of companies. DCF can serve as a reality check to the fair value prices found in brokers' reports. DCF analysis requires one to think through the factors that affect a company, such as future sales growth and profit margins. It also makes you consider the discount rate, which depends on a risk-free interest rate, the company's costs of capital and the risk its stock faces. Let's begin by looking at how to determine the forecast period for your analysis and how to forecast revenue growth.
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4 (II) Forecasting - 1 Forecast Period The first order of business when doing discounted cash flow (DCF) analysis is to determine how far out into the future we should project the cash flows. For the purposes of our example, we'll assume that The Widget Company (“TWC”) is growing faster than the gross domestic product (GDP) expansion of the economy. During this "excessive return" period, TWC will be able to earn returns on new investments that are greater than its cost of capital. So, our discounted cash flow needs to forecast the amount of free cash flow that the company will produce for this period.